# (SOLVED) A trader, who is considering uncovered interest arbitrage between the US dollar (USD) and Australian dollar (AUD), faces the following data:

Discipline: Finance

Type of Paper: Question-Answer

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Question

A trader, who is considering uncovered interest arbitrage between the US dollar (USD) and Australian dollar (AUD), faces the following data:

Funds available:     2 million USD

Spot exchange rate:    0.94 AUD per USD

Spot exchange rate one year ago:    1.00 AUD per USD

USD 3-month interest rate:     0.12% per annum

AUD 3-month interest rate:  4.69% per annum

(1) Calculate the profit that would be made if the exchange rate remains at its current level in three months' time;

Borrow USD 2,000,000 for 3 months. USD to repay after 3 months

= 2,000,000 (1 + (0.12% * (3/12)))

= USD 2,00,600

Convert the borrowed USD into AUD at the spot exchange rate.

AUD received = 2,000,000 * 0.94

= AUD 1,880,000

Invest the AUD for 3 months.

AUD received after 3 months = 1,880,000 (1 + (4.69% (3/12))) = AUD 1,902,043

After 3 months convert the AUD back into USD.

USD received = 1,902,043/0.94

= USD 2,023,450

Profit = USD received after 3 months - USD to repay after 3 months Profit

Profit = 2,023,450 - 2,000,6000 Profit = USD 22,850

(2) How would the profit figure change if the Australian dollar continues to strengthen at the same rate as it has done over the past year?

Expert Solution Preview

In the example given in the question we assume that foreign exchange rate remains the same for 3 months at 0.94 AUD/USD.

Let us calculate the AUD appreciation percentage.
Appreciation/Depreciation formula = (value of previous year - value of this year$\frac{}{}$)/value of previous year
= (1AUD/USD- 0.94AUD/USD)/1AUD/USD) = 0.06 = 6%

If the value is negative then the currency has...............